Sunday, July 23, 2017

The importance of quickly eliminating bad prospects

Last
year, Matt Brice wrote a nice article called Think Fast – Lessons for Dating, Investing. The article's message is that, whether in love
or investing, people should eliminate bad prospects quickly so that
“By spending less time with those who are not a match, you get to
spend more time with the one who is a match.”

I
can't comment on Matt's dating life, but this is great advice for
investing. There are 10,000 publicly-traded companies around the
world, far more than any one person can follow. Finding the ones that
are undervalued, or are excellent businesses, means quickly filtering
out the majority that aren't.

The
article mentions a dozen kinds of investments he filters out out,
including fashion retailers, scammy businesses like payday lenders
and for-profit colleges, and companies that depend on a single
powerful customer (e.g. Wal-Mart suppliers).

I
agree with those, and I also like his broader point that each
investor should make his own list. While some companies are
intrinsically better than others, everyone has a different personality
and different experiences, and investing success depends in part on
finding investments that mesh well with those.

With
that caveat, here's my list:

Fashion
retail. I started life as a value investor and have gradually drifted
toward macro investing. I don't think either methodology works for
retail. Fashion retailers lack the margin of safety value investors
seek: most don't have durable brands, and if they fail, their assets
(leasehold improvements, ugly clothes) are worth little. And while
recessions hurt retailers and economic growth helps them, they also
can succeed or fail for reasons that have nothing to do with the broad
economy.

Secular
growth stories. These are hard to predict. Apple has experienced
phenomenal growth and profitability since 2003, but from 1980-2003,
its stock barely kept pace with inflation. Monster Beverage (formerly
Hansen Natural) is one of the all-time great growth companies, but
before its energy drink took off, it was a middling juice company
that had unsuccessfully tried selling soy drinks and nutrition bars.

Declining
businesses. I find these hard to predict too. A decade ago, I assumed
GameStop would be out of business by now, but it's still minting
money. When a business becomes obsolete and fails, there are always
warning signs that it would happen, yet many companies have the same
warning signs but manage to fend off obsolescence.

Venture
capital. I'm a big fan of Jerry Neumann's writing. One arguments he's
made is that some of the best venture capitalists have achieved success by embracing uncertainty rather than risk. E.g., they invest
in companies for which the market opportunity is essentially unknown.
That's the opposite of what I do: I look for situations that have
definite historical precedents so that I feel the odds are knowable. VC seems
to be full of opportunity, but doing it successfully would go against
all the research I've done and habits I've developed so far.

Fraudulent
companies. There's a well-known short seller named Marc Cohodes who
publicly attacks companies he thinks are frauds. He has a strong
record that includes exposing Lernout and Hauspie back in 2000.
Unfortunately, many of his shorts double before they implode. He's
also been sued by companies he's criticized. I think Cohodes is
willing to endure these risks because he has the personality of a
street brawler and enjoys fighting slimy companies. I don't and would
hate to be sued.

There
are other reasons why shorting frauds isn't attractive: it's popular
among long-short hedge funds, so frauds usually have a high cost to
borrow, and the rise of passive investing means that a growing number
of investors don't care about business quality.

Health
care. Health care is insanely expensive in the United States, and I
think we're just one populist Democrat away from reforms that crush the industry's profitability. There's also a contradiction inherent
to health care, and in particular pharmaceutical drugs: the most
profitable products are rarely the most effective, while many of the
best ideas get little attention because they aren't moneymakers. A cure
has to be taken only once, so it's less profitable than a drug that
alleviates symptoms but doesn't offer a cure and has to be taken for
the rest of one's life.